Futures markets

1. Futures markets

2. Futures and Forwards • Forward - an agreement calling for a future delivery of an asset at an agreed-upon price • Futures - similar to forward but feature formalized and standardized characteristics • Key difference in futures • Secondary trading - liquidity • Marked to market • Standardized contract units • Clearinghouse warrants performance

3. Key Terms for Futures Contracts • Futures price - agreed-upon price at maturity • Long position - agree to purchase • Short position - agree to sell • Profits on positions at maturity Long = spot minus original futures price Short = original futures price minus spot

4. Figure 22.1 Futures Listings

5. The trader holding the long position • Purchase the good, profits from price increases • Short position loss is equal to long position profit • Profit to long = Spot price at maturity – Original future price • Profit to short = Original future price – Spot price at maturity • Zero sum game

6. Figure 22.2 Profits to Buyers and Sellers of Futures and Option Contracts

7. Figure 22.3 CBOT Trading Volume in Futures Contracts

8. Existing Contracts • Variety of goods in 4 great categories • Agricultural commodities, metals and minerals, foreign currencies, financial futures • Electricity or weather futures and option contracts • Prediction market • Forward market in foreign exchange

9. Table 22.1 Sample of Future Contracts

10. Trading Mechanics • Eurex • Globex • Clearinghouse - acts as a party to all buyers and sellers. • Obligated to deliver or supply delivery • Position = zero • Closing out positions • Reversing the trade • Take or make delivery • Most trades are reversed and do not involve actual delivery • Open Interest

11. Figure 22.4 A, Trading without a Clearinghouse. B, Trading with a Clearinghouse

12. Margin and Trading Arrangements • Total profit or loss by long trader • Ft – F0 • Short trader earn • F0 - Ft • Initial Margin - funds deposited to provide capital to absorb losses • Marking to Market - each day the profits or losses from the new futures price are reflected in the account. • Maintenance or variation margin - an established value below which a trader’s margin may not fall.

13. Margin and Trading Arrangements Margin call - when the maintenance margin is reached, broker will ask for additional margin funds Convergence of Price - as maturity approaches the spot and futures price converge Delivery - Actual commodity of a certain grade with a delivery location or for some contracts cash settlement Cash Settlement – some contracts are settled in cash rather than delivery of the underlying assets

16. Cash versus Actual Delivery • Most contracts call for delivery of an actual commodity • Quality can vary • Higher or lower grade commodities • Some contracts call for cash settlement • St- F0

17. Trading Strategies • Speculation - • short - believe price will fall • long - believe price will rise • Hedging - • long hedge - protecting against a rise in price • short hedge - protecting against a fall in price

18. Futures market Strategies • Hedging and speculations • Speculators • Lower transaction costs • Leverage • Margin not value of the asset underlying the contract

20. Futures market Strategies • Hedgers • Insulate against price movements • Not possible for some goods • Future contract is not traded • Cross hedging

22. Figure 22.5 Hedging Revenues Using Futures, Example 22.5 (Futures Price = $67.15)

23. Basis and Basis Risk • Basis - the difference between the futures price and the spot price • over time the basis will likely change and will eventually converge • On the maturity date of a contract, the basis must be zero • Basis Risk - the variability in the basis that will affect profits and/or hedging performance • Calendar spread

26. Futures Pricing Spot-futures parity theorem - two ways to acquire an asset for some date in the future • Purchase it now and store it • Take a long position in futures • These two strategies must have the same market determined costs

27. Spot-Futures Parity Theorem • With a perfect hedge the futures payoff is certain -- there is no risk • A perfect hedge should return the riskless rate of return • This relationship can be used to develop futures pricing relationship

29. Rate of Return for the Hedge

30. General Spot-Futures Parity Rearranging terms

31. Arbitrage Possibilities • If spot-futures parity is not observed, then arbitrage is possible • If the futures price is too high, short the futures and acquire the stock by borrowing the money at the riskfree rate • If the futures price is too low, go long futures, short the stock and invest the proceeds at the riskfree rate

32. Future Market Arbitraga

33. Spread • Relation between future prices of contracts of different maturity days • Futures price is in part determined by time to maturity • If rf > d

34. Figure 22.6 S&P 500 Monthly Dividend Yield

35. Spread Pricing: Parity for Spreads

37. Figure 22.7 Gold Futures Prices

38. Theories of Futures Prices • Expectations • Normal Backwardation • Contango

39. Figure 22.8 Futures Price over Time, in the Special Case that the Expected Spot Price Remains Unchanged